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Bloopers & Blunders: Asset Allocation an Art?

Quotation

"Mr. Kerschner, who uses a quantitative approach to analyzing the market, has a strong track record. In The Wall Street Journal's quarterly study of asset allocation -- the art of dividing a portfolio between stocks, bonds, cash and other investments -- he led a field of major brokerage-house strategists in 1987, 1990 and 1993." (WSJ, July 31, 1996)

Answer

Since when is "quantitative approach" an "art?"

Some Background

A portfolio manager who follows an "asset allocation strategy" attempts to find the best proportions to be invested among different classes of assets. Typically the class alternatives are stocks, bonds, and cash. Thus, under such an investment strategy, or approach, there is no attempt to predict the performance of each individual stock, i.e., which ones are under- and which are over-priced. Rather, the stock market is considered a single aggregate class whose performance is typically measured by the S&P 500.

Similarly, a bond-index, say, that of long-term U.S. Treasury, is used as a second asset class. As for cash, certificate of deposits (CDs) are used as the third asset class.

Note that, although real estate can be a forth class, it is typically excluded from what is referred to as "asset allocation." One possible explanation is that real estate analysis is not as quantitative as the analysis of the other asset, and is probably more of an "art."

Quantitative Approach

A quantitative approach to asset allocation is a two step procedure. First, expected return on each of the three classes of assets (stocks, bonds and cash) is estimated, then money is allocated among them based on the estimated expected return. Quantitative models are typically used to obtain these estimates.

Consider the following example:

A money manager, using quantitative methods, obtains the following estimates for expected returns for the next 6 months: stocks at 25%, bonds at 8%, and CDs at 5%. It does not require a genius to figure out that you should put a larger proportion of the portfolio in stocks.

What might be tricky, however, is coming up with the best proportions, i.e., the proportions that are expected to result in the highest return over the next 6 months. Thus, given the same estimated returns above, one manager might decide to allocate 100% of the money in stocks, while another 80% in stocks and the rest in bonds. Although there isn’t a precise formula to calculate the best proportions for each asset class, the allocation process is hardly an "art."

By Alex Tajirian